What’s Right With Finance

Morgan Housel wrote a great piece this week called What’s Wrong With Finance where he laid out four problems that stem from the fact that finance is strange in so many ways. Here were his four problems:

Problem No. 1: Extreme bias toward action, mostly due to exploitative fee arrangements.

Problem No. 2: An overuse of numbers and formulas and an underuse of psychology and sentiments.

Problem No. 3: No consistent measures of performance.

Problem No. 4: People have no money when compound interest is in their favor, and lots when it’s not in their favor.

I’ve seen firsthand how each of these problems can make it difficult for investors to make rational decisions. But Morgan’s piece got me thinking about the other side of this – what’s right with finance? Here are four things I think finance gets right.

No. 1: It’s a System Based on Trust. At times it boggles my mind that the financial markets function as smoothly as they do day in and day out. When you really think about it, the entire system is based almost exclusively on trust. No one really knows what any public company is worth since today’s value is based on uncertain future cash flows. There’s more guessing that goes on than people care to admit. And very few investors actually understand all of the interconnected, behind-the-scenes work that allows the system to function as it does. I’m in awe sometimes that we were able to create the financial markets in their current form.

To explain the markets to those outside of the world of finance, I like to give the analogy of a driving your car through an intersection with a traffic light. When the light is green you drive straight through without a second thought. You don’t stop to look both ways before going through. You trust that everyone else will follow the rules and stop if their light is red. But every once and a while someone runs a red light and there’s an accident. That’s basically how the markets work. Sometimes the trust gets called into question after an accident, but it always seems to come back eventually. Without faith in the system it wouldn’t work.

No. 2: You Get to Put Your Money Where Your Mouth Is. What’s the single best way to invest? Ask this question and you’re sure to get a different answer from traders, buy-and-hold investors, stock-pickers, trend-followers, robo-advisors, quant investors, macro hedge fund managers, technical analysts, long/short investors, indexers or any number of other investment philosophies.

Want to see investment professionals get into a heated debate? Ask them their thoughts on the Efficient Market Hypothesis. Or the relative merits of active vs. passive investing, the correct historical data with which to base their back-tests on, how much you should pay for financial advice, whether or not the market is over/undervalued, the future direction of interest rates and so on.

If there were no differences in opinions between market participants, the markets wouldn’t function properly. We need there to be two sides to every trade. Let’s say you received an early copy of the Fed’s statement from yesterday afternoon. You could have given that statement to another investor after looking it over and both of you would have interpreted the market’s potential reaction to the statement in completely different ways. Even if you could gain access to information before other investors, it still tells you nothing about how investors will react to that information. Investors form their opinions based on their experiences, perception of risk and their perception of the perception of others. This is why there is always a buyer for every seller.

Think about it this way – at least 50% of all investors (and many more after accounting for costs and behavior) are taking one for the team and underperforming the markets. Certain investors have to lose for others to win. But there are also winners and losers over different time horizons. I could be wrong about the short-term but still do quite well for myself over the long-term while the person on the other side of our trade could make out like a bandit over the short-term but still lose their shirt over the long-term. Or the reverse could be true. The variations are endless.

But there will always be other investors lining up to take the other side of your trade in hopes of outsmarting you and hopefully, not outsmarting themselves. Even those investors that lose on a consistent basis will continue to come back for more as hope springs eternal.

People can’t agree on anything these days and that’s a good thing for the financial markets and for those investors that are rational enough to take the other side of the decisions made by irrational investors.

No. 3: Investors Are Constantly Sharing & Collaborating. How many other professions outside of finance do you know of that have a majority of the greatest minds in the field sharing their wisdom through books, publicly available client memos, shareholder letters and interviews? Marks, Dalio, Buffett, Munger, Lynch and many others have all made it a point to share their past successes and failures in the markets. The greats want individual investors to learn from their experiences. Even though you will never be the same type of investor as them, standing on the shoulders of giants is possibly the best way to learn about how the markets actually work and the importance of emotional intelligence.

Just this week Bill Gates wrote about how great it is that Warren Buffett shares so much wisdom in his annual shareholder letters:

I am lucky to call Warren a friend and to be able to learn from him personally. (I also serve on Berkshire’s board and own stock in the company.) The fact that everyone who cares about business and finance can benefit from his wisdom—just by reading these annual letters—is pretty amazing.

I agree.

No. 4: The Markets Are Kind Of, Sort Of, In a Round-About Way, Efficient. The markets don’t get everything right. And when they make a mistake, investors are quick to point out how inefficient they are. But these huge inefficiencies are rare compared to the trillions of dollars in activity that takes place on a daily basis in the various markets. Investors have to process an incalculable amount of data, news, past experiences and expectations about the future, which all filters down into the price-setting process. Markets mostly get it right most of the time. Sure there are short-term inefficiencies, but investors wouldn’t be successful if markets weren’t fairly efficient over the long-term.

Plus, you have this cycle where certain investors discover a strategy that works in the markets. Eventually those ideas find their way into academic research, which becomes widely disseminated, consumed and used by other market participants. Finally those ideas become mass market and fail to work anymore – either for a period of time or maybe forever, depending on the anomaly. These cycles are speeding up because of the ease of access to information and the competition for outperformance from all corners of the investment world.

Having others take out short-term inefficiencies is a great thing for actual investors, because it only reinforces the idea that those with a well-thought out long-term process can still succeed if they’re patient.

I agree with Morgan that there are many areas of finance that don’t make much sense. But I’m also fascinated with the evolution of the public markets. It’s not a perfect system, but it allows investors to allocate their capital in a myriad of different investment options, facilitate the sharing of ideas and allows corporations to raise capital in a fairly efficient manner.

Sources:
What’s Wrong With Finance (Motley Fool)
Warren Buffett Just Wrote His Best Annual Letter Ever (Gates Notes)

Further Reading:
Is Technology Speeding Up Market Cycles?
What Happens When the Umbrella Shop Gets Too Crowded?

Here’s what I’ve been reading this week:

  • The long-term only matters if you have a plan for how to deal with it (Bason)
  • Not all index funds are created equal (Irrelevant Investor)
  • How the framing effect can impact historical market analysis (Alpha Architect)
  • Questions investors simple don’t ask themselves (My Own Advisor)
  • How the cash allocation with the new robo-advisor from Charles Schwab is like free chocolate (Finance Buff)
  • Trusting an advisor costs something, but also lowers stress levels (Alpha Architect)
  • 5 rules of business (Medium)
  • How over-thinking kills your performance (Psychology Today)
  • A dozen lessons about investing and life from Morgan Housel (25iq)
  • How emotional intelligence can make you a better investor (Institutional Investor)
  • Why fear is a mind killer (Millennial Invest)
  • Video: Reading should be part of your job as an investor (Reformed Broker)
  • Jesse Livermore: “Investors are trained to think that volatility is a bad thing–but it’s actually a good thing, at least for long-term shareholders. It mathematically increases their total returns.” (Philosophical Economics)

 

 

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  1. innerscorecard commented on Mar 20

    I agree with all your points. Even more fundamentally, having financial markets is crucial to capitalism, and capitalism improves human lives more than any other economic system. That doesn’t mean the current state of financial markets is perfect, but it’s not bad. For all that Warren Buffett, Charlie Munger and the like talk about how they just won the ovarian lottery, and trading derivatives is a license to steal, and the like, it’s certainly better than a system where how fast you rise is based on your relationships with various cliques in the Communist Party and your ability to interpret political will.

    • Ben commented on Mar 20

      I’d agree with that assessment, but I don’t think there will ever be a perfect system. There are many ways in which it could be improved but I think it’s much better than most people assume.

    • Steve commented on Mar 21

      Didn’t you just describe the 1%?

  2. gbgasser commented on Mar 20

    Good article Ben but I think your point about information sharing somehow being unique to finance is off. Virtually all the science based fields have huge amounts of information sharing. Doctors are constantly trading ideas via journals and conferences in an effort to improve health care outcomes. Universities share almost all their research results and I know the Big Ten universities have a massive brain share network amongst their schools. Finance is far from unique in that regard. In fact, I would argue that most of those books in finance are simply ways to enrich the author and not give away advice. Especially since many of the books do NOT give anything helpful. Most of the people have NOT discovered some formula for constant success in financial markets. As Cullen has shown, their is no formula for winning forever and most guys simply were lucky for a period of time and simply think they were “smarter”.

    Your points about trust and putting your money where your mouth is are good.

    • Ben commented on Mar 20

      Sure but science research isn’t usually for the layperson to understand. It can be like reading Latin. If you know the sources to look for, those giving finance advice that’s understandable to a wider audience is fairly unique. And that includes people like Cullen and some of the other really good bloggers out there.

  3. Scott Boone commented on Mar 20

    What this article underscores for me is the importance of both an appropriate investment time horizon AND discipline. Too many investors say they are in for the long haul and then become virtual day traders when market volatility increases – chasing returns when markets move up or trying to protect principal when markets move down. Our standard practice was to meet with clients once a quarter to discuss their portfolios. Over time, I came to realize that this was probably counterproductive as clients expected us to tell them of the changes we had made to their portfolios in response to short term market movements and many were disappointed when we had made few, if any, changes. Once a year would be plenty, but few investors have the discipline to ignore the market noise for the other 364 days of each year.

    • Ben commented on Mar 20

      Interesting trade-off between communication and activity. Maybe a quarterly update as a supplement between annual meetings? Unfortunately most clients don’t like to hear “we didn’t make any changes to your portfolio and stuck with the plan.”

  4. MarketFox commented on Mar 20

    Great post. I agree that the opportunity to put your money where your mouth is, is one of the most interesting features of markets because it brings all sorts of people and ideas into contact – even conflict – with each other.

    Not so sure about markets being mostly efficient. As an institutional investor, I see a wide cross section of investor behavior every day and each year I become more and more convinced that a) the market is FAR from efficient and b) it will stay that way.

    Warren Buffett has written many times about the “institutional imperative” – the need to always be doing something, to copy what other investors are doing, to be overly concerned about short term performance, etc.

    For example, there’s the way that most people construct multi-manager equity portfolios, I’ve written about this in my blog:

    http://marketfox.org/2015/01/05/the-parable-of-the-seven-fund-managers/

    • Ben commented on Mar 20

      Sure there is irrational behavior but over the long haul stock returns tend to track dividends and earnings growth. Bonds return their starting interest rate. Even if it’s not a straight line to get there, it generally works out that way. And I’m sure even Buffett would agree that markets are fairly efficient over the long-term, otherwise his purchases when there is short-term irrationality wouldn’t work out.

      • MarketFox commented on Mar 21

        True there is mean reversion over a 7-10 year time frame. Unfortunately most people are on their 3rd or 4th different job by the time that happens.

        • Ben commented on Mar 21

          Yup. Which is why education, expectations and the right investors matter because of career risk. Even then it’s difficult to get investors to stick around.